What is the 'International Fisher Effect - IFE'
The international Fisher effect (IFE) is an economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time.
"E" represents the % change in the exchange rate
"i1" represents country A's interest rate
"i2" represents country B's interest rate
BREAKING DOWN 'International Fisher Effect - IFE'For example, if country A's interest rate is 10% and country B's interest rate is 5%, country B's currency should appreciate roughly 5% compared to country A's currency. The rationale for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates.
The IFE is based on the analysis of interest rates associated with present and future risk-free investments, such as treasuries, and is used to help predict currency movements. This is in contrast to other methods that solely use inflation rates in the prediction of exchange rate shift, instead functioning as a combined view relating inflation and interest rates to a currencies appreciation or depreciation.
The theory stems from the concept that real interest rates are independent of other monetary variables, such as changes in a nation’s monetary policy, and provide a better indication of the health of a particular currency within a global market. The IFE provides for the assumption that countries with lower interest rates will likely also experience lower levels of inflation, which can result in increases in the real value of the associated currency when compared to other nations. By contrast, nations with higher interest rates will experience depreciation in the value of their currency.
The Fisher Effect and the International Fisher Effect
The Fisher effect and the IFE are related models, but are not interchangeable. The Fisher effect claims that the combination of the anticipated rate of inflation and the real rate of return are represented in the nominal interest rates. The IFE expands on the theory, suggesting that currency changes are proportionate to the difference between the two nation’s nominal interest rates.
The Relevancy of the International Fisher Effect
In times where interest rates were adjusted by more significant magnitudes, the IFE held more validity. However, the consumer price index (CPI) is more often used in the adjustment of interest rates within a specified economy.